Asymmetric Allocation: 3 Reasons Why SRCL/SMED Is A Great Long/Short Reversion To The Mean Story

| About: SHARPS COMPLIANCE (SMED)
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Summary

Market-neutral trade: Longing Stericycle, Inc. at the same time shorting Sharps Compliance Corp.

Longing Stericycle: Current price as of 1/17/17 is $80.63. Morningstar's fair value estimate is $105.00.

Longing Stericycle: Magic Formula numbers are ROC of 56.22% and earnings yield of 5.40%.

Shorting Sharps Compliance Corp.: Magic Formula numbers are ROC -12.78% and earnings yield of -2.02%.

In this article, I write about a potential money making market-neutral trade that consists of longing Stericycle Inc. (NASDAQ:SRCL) and at the same time shorting Sharps Compliance Corp. (NASDAQ:SMED). In this article, I cover 3 key reasons why this is a high-probability trade. Before we get into 3 points, let me tell you more about the background of these two companies.

Companies

Stericycle, Inc. is a business-to-business services provider with a focus on regulated and compliance solutions for healthcare, retail and commercial businesses. Headquartered in Lake Forest, Illinois, the company's mission is to help its customers fulfill their promise by providing solutions that protect people & brands, promote health and safeguard the environment. It does this by offering services such as medical waste services, compliance training, information destruction, environmental solutions, sustainability services, communication solutions, retrieval/quality audits, recalls and sells products. In short, Stericycle is a global leader with a full suite of solutions that helps support thousands of organizations in caring for their customers, communities and environment. As you will see in my analysis, SRCL is a lean, mean, cash flowing machine where hardly anything goes to waste (pun intended).

Sharps Compliance Corp. is a provider of waste management services, including medical, pharmaceutical and hazardous. Its main office is in Houston, Texas. The company focuses on medical waste disposal management services and compliant healthcare waste management solutions. It offers the following services: medical waste disposal, pharmaceutical waste disposal, hazardous waste disposal, universal waste disposal, incineration & treatment services and compliance & training services. SMED competes in the following markets:

  • Healthcare Providers
  • Non-Healthcare Businesses
  • Pharmacies
  • Pharmaceutical Manufacturers
  • Government
  • Residential

In its recent financial history, SMED exhibits tight and negative profit margins. Although the company has had decent revenue growth of 21.12% year over year based on the latest quarter, its costs have resulted in negative EPS. The following analysis will show you that SMED has not been a healthy business. It could turn around, but in this horse race, my bet is on SRCL to win by a large margin. Per Morningstar, current Wall Street Annual EPS for SMED is -$0.03 (compared to average EPS estimate of $4.64 for SRCL).

Reason 1: Miracle Formula 2.0

My thesis is that you can create alpha (or excess return above the market return) by performing a market-neutral trade longing Group 1 Magic Formula ranked stocks and at the same time shorting Group 10 Magic Formula stocks in the same industry/sector with companies that have no M&A news. By longing the undervalued quality stock using the classic Magic Formula (the Group 1 stocks), you can find stocks that are heading to the heavens. By shorting the Anti-Magic Formula (the Group 10 stocks), you will likely find companies that will trade down to earth. Combining the long and short for no M&A stocks, you have the Miracle Formula 2.0 for market-neutral investing. This is heaven on earth.

Let's continue with an example of how Miracle Formula Investing works with SRCL and SMED.

Comparing the two Magic Formula Investing factors, we find that SRCL is more undervalued and has a better quality than SMED.

SRCL

SMED

ROC: EBIT / (Net Working Capital + Net Fixed Assets)

56.22%

-12.78%

Earnings yield: EBIT / Enterprise Value

5.40%

-2.02%

M&A News

No

No

Because SRCL ranks higher on both quality and value than SMED, SRCL is the better buy.

Reason 2: Check Long Side Valuations and Compare Quality of Short Side

It's always good to check your work and test your assumptions. Especially when there is money on the line. I like to use Morningstar and Value Line to see what they think. They have abundant resources and hundreds of analysts working to do great independent financial research for investors of all types.

Normally, I like to find companies where Morningstar/Value Line have valuations. In this case, there is only analysis on my long side of the market-neutral trade. However, with a little ingenuity, you can handicap the short side by some relative analysis.

The following is a summary of Morningstar's fair value estimate:

SRCL

SMED

Morningstar

105.00

N/A

Current Price as of 1/17/2017

80.63

4.42

Margin of Safety

23.21%

N/A

According to Morningstar, our long in SRCL looks healthy.

The following is a summary of Value Line's target price range in 3-5 years:

SRCL

SMED

Value Line Target Price Range Low

120.00

N/A

Value Line Target Price Range High

180.00

N/A

Value Line Target Price Range Average

150.00

N/A

Current Price as of 1/17/2017

80.63

4.42

Margin of Safety

46.25%

N/A

CAGR

16.79%

N/A

Since Value Line gives us a target price range, we can compute the compound average growth rate with a financial calculator assuming the average of the high and low target prices are reached in 4 years (average of 3 and 5 years). I estimate the CAGR for SRCL to be 16.79%, which is a really good annual return.

Now it's time to evaluate our short side to see if we can handicap it. This is a horse race. Although past performance does not indicate future performance, it may shed light on the subject, which would be enlightening (pun intended).

Returns

Please note that you should compare the company's return to its competitors, industry and sector when you are evaluating a company's returns. Each company operates in a different industry and sector. Therefore, results across different industries and sectors carry different risks, returns and averages.

Return on Equity (ROE)

Return on Equity measures the efficiency with which a company uses shareholders' equity and is a great overall measure on returns on capital. (Note: A flaw in using ROE is that a company can take on a lot of debt and boost ROE without becoming more profitable. Therefore, you should look at Return on Invested Capital).

ROE = Net Income / Shareholders' Equity

SRCL

SMED

Return on Equity

8.49%

-4.85%

SRCL ranks higher than SMED based on ROE.

Return on Assets (ROA)

Return on Assets measures how much income a company generates per dollar of assets. Investopedia defines ROA as follows: "An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as 'return on investment'."

ROA = Net Income / Total Assets

SRCL

SMED

Return on Assets

4.00%

-3.73%

Again, SRCL performed better than SMED based on ROA.

Return on Invested Capital (ROIC):

Return on Invested Capital combines the best of both worlds by measuring the return on all capital invested in the firm (both debt and equity). Does the company show a consistently high return on total capital (above 12%)?

ROIC = (Net Income - Dividends) / Total Capital

SRCL

SMED

Return on Invested Capital

5.38%

-22.99%

A similar trend is found when we handicap SRCL and SMED based on ROIC. SRCL is the clear winner.

Return on Capital (NYSE:ROC)

ROC = EBIT / (Net Working Capital + Net Fixed Assets)

EBIT is used because companies operate with different levels of debt and differing tax rates. By using EBIT, you can compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.

Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in ROA) or equity (used in ROE). It figures out how much capital is needed to conduct the company's business. Net Working Capital is used because a company has to fund receivables and inventory. Net Fixed Asset is used because a company has to fund the purchase of fixed assets to conduct business (i.e., real estate, plant and equipment).

SRCL

SMED

Return on Capital

56.22%

-12.78%

This is one of the Magic Formula and Miracle Formula factors. As we can see, SRCL is the better-quality stock when we base it on ROC.

Free Cash Flow (FCF) per Sales:

Free Cash Flow = Cash Flow from Operations - Capital Spending

Free Cash Flow per Sales = FCF / Sales

Anything above 5% is doing a solid job at generating excess cash. Combining this ratio with ROE, you can divide companies into 4 categories.

High ROE

Low ROE

FCF / Sales > 5%

1

2

FCF / Sales <= 5%

3

4

Companies in Quadrant 1 are likely wide economic moat companies; companies in Quadrants 2 and 3 are less desirable; while those in Quadrant 4 are likely the least desirable.

SRCL

SMED

Free Cash Flow per Sales

10.49%

-9.98%

Return on Equity

8.49%

-4.85%

Based on these figures, SRCL is a highly desirable Quadrant 1 possibly (or Quadrant 2). In contrast, SMED appears to be a Quadrant 4 company.

We also saw how SRCL is apparently undervalued, based on Morningstar and Value Line's research. However, we need to do further analysis to determine whether or not we should short SMED.

Reason 3: Reversion to the Mean

Playing for reversion to the mean. In this case, what would the companies be valued at if they had industrial P/E, P/S and P/B ratios. We will be performing relative valuations, which are not exact as the popular Discounted Cash Flow and Residual Income models for valuations. However, we don't need to be exact, because we are placing a market-neutral trade which is betting on relative performance of the two stocks.

The following is a relative P/E valuation of SRCL and SMED. Please note that SMED does not have positive EPS, and it is not projected to have a positive EPS based on Wall Street estimates. However, if we assume it made $0.01, we can see that it is trading at higher multiples than SRCL.

SRCL

SMED

SMED if it had earnings of $0.01

Price-to-Earnings (TTM)

29.00

(63.14)

442.00

Price-to-Earnings (Forward)

17.38

(147.33)

442.00

Price-to-Earnings (Industry Average)

36.20

36.20

36.20

EPS

2.78

(0.07)

0.01

EPS Estimate

4.64

(0.03)

0.01

Implied Valuation (TTM)

100.64

(2.53)

0.36

Implied Valuation (Forward)

167.97

(1.09)

0.36

Implied Valuation (Average TTM and Forward)

134.30

(1.81)

0.36

From the reversion to the P/E mean, we see SRCL is a relative buy compared to SMED.

The following is a relative P/S valuation of the two companies. Please note that you also want to factor in net margin into your analysis. Why? Because average sales times net margin equals net income, which when divided by shares outstanding gives you EPS. A higher net margin than the industry equates to greater EPS per average sale.

SRCL

SMED

Price-to-Sales

1.90

2.00

Price-to-Sales (Industry Average)

2.00

2.00

Sales per Share

41.69

2.19

Implied Valuation (P/S)

83.39

4.38

Net Margin (Industry)

-

-

Net Margin

7.60

(3.35)

When considering reversion to the mean for P/S, you see SRCL has some upside, while SMED is already trading at the P/S industrial multiple. In addition, comparing net margins, SRCL is the better buy.

So far, based on relative P/E and P/S valuations, SRCL has more upside potential and SMED has more downside potential. Let's look at the last relative P/B valuations to see who's the winner. Any guesses?

SRCL

SMED

Price-to-Book

2.40

2.80

Price-to-Book (Industry Average)

3.40

3.40

Book Value per Share

33.47

1.57

Implied Valuation

113.80

5.34

You probably guessed it, SRCL is a better buy relative to SMED, based on P/B valuations. You're right!

Conclusion

Are the valuations precisely correct? No one can give an exact value of a company, but you have a range of confidence. As Warren Buffett says, "It is better to be approximately right than precisely wrong." Please note that the fair value estimates relied primarily on relative valuations. Therefore, the numbers really express more of the relationship of price and value rather than a hard and fast number. However, if past performance is an indicator, then we find SRCL is a better-quality company compared to SMED.

Do you need a more precise valuation? It may be nice to have one, so based on Value Line and Morningstar, our long SRCL seems to fit the more precise undervalued valuation. We analyzed the quality of these two stocks and came up with relative valuations. We found SRCL is a relatively better quality and value compared to SMED. Based on this fundamental analysis, it has a high probability of outperforming SMED on a relative basis. This is the reason why I believe longing SRCL and shorting SMED is a great market-neutral trade.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.